The Finance Professionals' Post educates readers in the finance and banking sectors on the forces that shape their business. The FPP is a publication of the New York Society of Security Analysts (NYSSA).

06/23/2014

Forward Thinking on Collateral Management

Most financial firms in the present day would need an overhaul of their current collateral management practices. This comes in the midst of the burden being experienced by an already intensely regulated financial industry and the new measures of regulation on OTC derivatives in the post financial crisis world. The costs of regulation are near-crippling to some firms. Big dealers are planning to exit or divest certain lines of business that will face huge operational costs as a result of regulation, and are no longer deemed profitable.

Collateral management is nearly in place at the big dealer firms. However, it has become forever important for both big and small firms now to highly optimize collateral requirement calculations. The ability to optimize collateral and the speed of delivery have become very important in a cost conscious financial industry; these abilities alone could lead to a comparative advantage among players. And firms could very well pay heavily for inadequacies in these areas. This reasoning is supported by two facts.

First, the street has moved to using funding curves to price and value OTC derivatives. However, as the underlying funding curve changes, it results in simultaneous movements in funding, pricing, and risk. A component called “funding risk” is created, that now falls in the hands of risk management.

Second, in order to trade in the current world of OTC derivatives, most liquid of which the CFTC requires for mandatory clearing directly with the CCP at the time of execution, it is now required that buy side firms alone post a collective collateral of an excess of $1 trillion dollars in cash and deliverable instruments. Hence, an assessment of funding risk becomes important at a time when capital is scarce and needs to be efficiently deployed into strategic ventures and revenue generation streams. In order to take an inventory of the available capital and to channel it efficiently between the CCP and actual lines of business of the firms, business intelligence must be built.

The hardest hit due to this demand in present day financial world would be unquestionably the buy-side firms. They seem to have had crude but somewhat functional forms of collateral management, but in most cases, the pieces of this new puzzle existed in a disparate and scattered fashion for them. The impact of the new requirements will require a complete transformation and consolidation with their existing trading systems. The new process will require them to estimate their operational costs of clearing and collateral management and a major investment into systems that optimize collateral for them. The costs for dealer firms cannot be ignored as well. They will have heavy operational costs of constant monitoring and surveillance on collateral.

While regulatory initiatives are often unwelcome by trading and might make the players uneasy, the end goal is hopefully beneficial to all. This game could result in a win-win for most parties in the near to medium run. Players in the market that have off-the-shelf sharp tools that can integrate and deliver collateral management solutions at quick speed will be the first winners. With regard to firms that are getting to collateral management initiatives in a more systematic fashion, it will enable them to build a global repository of cash and collateral. If this is done well, efficient mechanism for monitoring trade risk, margins at the CCP and calculating the cost of funding, and the most efficient ways of posting collateral can be devised. From the perspective of the clearing house, the transaction costs of clearing and collateral posting would be standardized and highly transparent. In terms of market as a whole, it will revert firms into thinking about cost of capital, what revenue streams are worth the risk, and how much this risk could potentially cost them – access to this information will be readily available when collateral management systems are in place. The new marketplace is a game changer and will lead to higher efficiencies in managing capital.

–Kavita Sastry, Owner & Director, Seriopus Group, Inc.

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